Question

. Using the Aggregate Expenditure model, explain the effect of each of the following on the level of aggregate expenditure and equilibrium GDP in a mixed-open economy. Assume that other factors are held constant. Draw a separate diagram in each of the case.  

a) A sharp rise in stock prices (3 marks)

b) A rapid appreciation of the national currency (3 marks)

Answer 1

In following graphs, initial equilibrium is at point X where initial aggregate expenditure line PAE0 intersects 45⁰ line with initial equilibrium aggregate expenditure E0 and equilibrium real GDP (output) Y0.

(a)

Higher stock price will increase consumer wealth, increasing consumption. The consumption line will shift upward from C0 to C1, and accordingly, aggregate expenditure will increase, and PAE0 will shift upward to PAE1. New equilibrium is at point Y where PAE1 intersects 45⁰ line with higher equilibrium aggregate expenditure E1 and higher output Y1.

(b)

Appreciation of national currency will decrease exports and increase imports, thereby decreasing net exports. The Net Exports line will shift downwardward from NX0 to NX1, and accordingly, aggregate expenditure will decrease, and PAE0 will shift downward to PAE1. New equilibrium is at point Y where PAE1 intersects 45⁰ line with lower equilibrium aggregate expenditure E1 and lower output Y1.